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Price Rises For Fuel Threaten Airline Net

By

Susan Carey

Updated Jan. 13, 2011 12:01 a.m. ET

Rising fuel prices threaten to play havoc with U.S. airline profits again this year.

In July 2008, spot crude prices peaked at $145 a barrel, then plunged to $30 a barrel by December of that year. Airlines that hadn't been hedging their fuel costs by buying complex financial instruments were slammed by the high prices, but those that did hedge posted big losses when the price collapsed and they had to buy fuel at above the market price.

For 2010, the U.S. airlines are expected to report their first profit in three years, but with oil prices hitting more than $90 a barrel recently and possibly headed higher, one of the carriers' top two expenses for 2011, along with labor, could be a make or break line item.

Southwest Airlines Co.
LUV 0.43%
, which benefited from a big bet on hedging a few years ago, is spending $150 million this year to lock in prices, said Laura Wright, chief financial officer of the nation's No. 4 airline by traffic. Sixty percent of Southwest's 2011 volume is covered up to $90 a barrel; 55% at up to $95 a barrel; 30% at up to $105 and 55% above $105, she said.

Hedging "is about knowing what your costs are going to be. It's certainty," Ms. Wright said in an interview. She added that Southwest has saved a net $3.5 billion by hedging since 2000.

US Airways Group Inc.,
by contrast, let its hedge positions expire in mid-2009 and figures it saved $126 million in the first nine months of 2010 by buying jet fuel on the open market. Hedging is "a large wealth transfer from industrial companies to Wall Street trading desks," Scott Kirby, the US Airways president, said in an interview. "It's an incredibly expensive insurance policy."

Southwest Airlines., which benefited from a big bet on hedging a few years ago, is spending $150 million this year to lock in prices. US Airways Group let its hedge positions expire, calling it an "incredibly expensive insurance policy." Here, a Southwest plane at Love Field in Dallas.
Bloomberg News

But now the No. 5 carrier by traffic is paying for its principles. For last year's fourth quarter, when prices took off, "we will have among the highest cost of fuel," Mr. Kirby acknowledged.

Airlines' vulnerability to volatile fuel prices is a fact of life, though, he added, and it is usually balanced out because rising fuel prices generally coincide with a stronger economy, which helps the bottom line.

When companies use hedging to "place a bet on the future," spectacular losses and even liquidation can result, added Mike Lovett, president of Muse, Stancil & Co., an energy consulting firm. Those who use the practice as a risk-management tool, stay on top of their positions, manage them, and trade in and out tend to be more successful, he added. "But they're always at risk of being caught out."

Most major airlines do hedge a portion of their fuel consumption. For instance,
Delta Air Lines Inc.
DAL 1.07%
has disclosed that it is hedged this year for about 40% of its consumption at $85 a barrel;
Alaska Air Group Inc.
ALK 2.24%
is 50% hedged at $86 a barrel.

Stifel Nicolaus airline analyst Hunter Keay believes high oil prices are good for airlines because they reinforce the industry's recent capacity discipline, may trigger additional passenger fees, and keep new airlines from starting up.

"While a $20 a barrel increase in crude oil certainly lowers our near-term estimates, we believe many investors are ignoring industry-wide benefits that occur in direct response to high and volatile oil prices," he said in a research note last week.

But Raymond James & Associates analyst Duane Pfennigwerth believes airlines remain highly vulnerable to pricey jet fuel. If carriers can't raise 2011 revenue above Wall Street forecasts, he doubts some of them will meet their 2011 profit estimates, he said in a recent note.

Crude oil futures hit $91 a barrel just before Christmas, a high not seen since October 2008. Airlines use jet fuel, which is even more costly, and is now going for nearly $110 a barrel.

Bella Goren, CFO of American Airlines parent
AMR Corp.
AMR -7.29%
, said at an investor conference last month that the company is "paying close attention to the recent upward swing in oil prices." But with its fleet getting younger and more fuel efficient, its financial health improving and a "prudent" hedging program in place, she said, "the specter of higher fuel costs is not the threat it was a couple of years ago."

So far, airlines have generally been able to more than keep pace with higher fuel costs through fare increases, surcharges on high-demand travel days and accelerating revenue from items such as change fees and charges for checked luggage. Airlines are also benefiting as business travel rises, bringing higher fares for last-minute travel, coming out of the recession.

But carriers paid about $8 billion more for fuel in 2010 than in 2009, excluding the effects of hedging, the Air Transport Association said.

Besides hedging, there are few tools carriers can use if fuel goes to $100 a barrel or more. Cutting capacity by reducing the number of available seats and aircraft in service is the main weapon airlines wielded when oil spiked in 2008.

By eliminating money-losing routes, carriers were able to save, and they had more opportunities to increase fares on the routes that remained.

But the major network airlines are already offering 13% less capacity now than they did in 2006.